Japan's services producer price index rose 3.6% year on year in July, accelerating from a revised 3.4% increase in June and exceeding market expectations, according to data from the Bank of Japan.

The rise is significant because service prices are more closely linked to domestic wage and cost pressures than prices of imported goods. It suggests that companies are increasingly passing higher labor and operating costs on to customers, making Japan's inflation less dependent on external shocks alone.

The latest services data followed the release of July consumer inflation figures. Japan's core consumer price index, which excludes fresh food, rose 1.8% from a year earlier, up from 1.6% in June and marking a second consecutive monthly acceleration. A measure excluding both fresh food and energy increased 1.9%, according to government data.

Headline consumer inflation stood at 1.9% in July. Taken together, the figures point to a broader price trend. Japan is still facing strong pressure from imported goods and energy, but price increases are gradually reaching services, where persistent inflation could become more deeply embedded in the domestic economy.

That is particularly important for the BOJ after years in which Japan struggled to generate sustained inflation. A temporary jump in import prices can fade when commodity prices or exchange rates stabilize. But service inflation driven by wages and domestic costs is harder to reverse without weaker demand or tighter monetary policy.

The weakened yen keeps import pressure alive

The currency remains at the heart of the problem.

The yen was trading around 159.3 per dollar on Thursday, keeping it close to the 160 level despite growing expectations for a BOJ rate hike.

A weaker yen makes imported energy, food and raw materials more expensive in domestic currency terms. That pressure is already visible in Japan's upstream price data: The country's producer price index rose 7.2% year on year in July, while the yen-based import price index jumped 29.1%.

Trade data also shows why the foreign-exchange market matters for Japan's inflation outlook.

Japan recorded a 634.5 billion yen trade deficit in July, as imports jumped 27.8% year on year, outpacing a 23.2% increase in exports.

The trade figures matter for the yen beyond their headline deficit. Japanese importers need foreign currency to pay overseas suppliers. When the import bill rises, companies have a greater need to purchase dollars and other currencies, creating actual demand for foreign exchange and potentially adding to downward pressure on the yen.

That creates a difficult feedback loop: A weaker yen raises import costs, higher costs feed into corporate prices, and broader inflation increases pressure on the BOJ to tighten monetary policy.

Yet the same trade flows can keep the yen under pressure even when markets are already pricing-in a rate hike.

September rate hike moves into focus

The combination of broader inflation and a weak currency is making the BOJ's September meeting increasingly important.

The central bank raised its policy rate to 1% in June and left it unchanged in July. Its next policy meeting is scheduled for September 17-18.

Market expectations have shifted sharply. A Reuters poll found that 57% of economists expected the BOJ to raise its policy rate to 1.25% in September, compared with just 5% in the previous month's survey. 

BOJ Deputy Governor Ryozo Himino reinforced those expectations on Thursday, saying policymakers should pay greater attention to upside risks to inflation and arguing that timely rate increases could help prevent the need for more abrupt tightening later. He stopped short of explicitly signaling a September hike.

For the BOJ, the issue is therefore becoming less about whether Japan has inflation and more about how persistent that inflation will prove to be.

The central bank has to balance two opposing risks. Moving too slowly could allow higher import costs and service prices to become entrenched, while tightening too aggressively could weigh on household spending and business activity.

The yen adds another layer of uncertainty. Even as expectations for a September hike have risen, the currency remains near 160 per dollar. That suggests the interest-rate gap with the United States, global capital flows and Japan's demand for imported goods continue to offset some of the support that a tighter BOJ policy might otherwise provide.

For now, Japan's latest data offers a clear message: Inflationary pressure is spreading beyond imported goods and into services, while the weak yen continues to amplify the cost shock.

With the currency once again approaching 160, the September BOJ meeting could become a test not only of Japan's commitment to monetary normalization, but also of whether higher interest rates can finally help break the cycle of yen weakness and imported inflation.